California Commercial Agency Disclosures: Failing to Comply Results In the Loss of a Broker’s Commission and Rescission of the Lease or Purchase Agreement.

If you are a broker or principal involved in commercial real estate in California, you're likely aware of California Senate Bill 1171, which as of January 1, 2015 requires commercial brokers to provide the same agency disclosures to their principals that residential agents have had to provide for years.

You know that a disclosure must be made, but depending on who you ask, you may get different answers on what disclosures must be made (there are actually two), and when and how these disclosures must be made (the Civil Code is very specific and in most cases requires that the landlord/tenant, buyer/seller acknowledge receipt in writing). Further, these requirements apply even if a broker is only representing one party (landlord, tenant, seller, or buyer). In fact, a broker representing only a tenant or only a buyer is required to make these disclosures not only to that tenant or buyer but also to the other principal, the landlord or seller.  For your reference, these points the what, when and how of making the disclosures are outlined below. 

What's more important, though, is that you know how critical it is that you make these disclosures properly. As you'll see below, the simple answer is this: If you are a broker, failing to provide the disclosures at the right time and in the right form will cost you your commission and very likely a lawsuit filed by your principal(s). If you are a principal and your broker fails to provide these disclosures at the right time and in the right form, you could lose your deal and be dragged into litigation. Hard to believe? Read the case below because that's exactly what happened – a seller rescinded a day after signing a purchase agreement because a broker, who the court found to have acted "in a fair and neutral manner" failed to provide one of the required disclosures at the right time. 

Senate Bill 1171 is unique because it is not new law. Instead, it expands existing law that used to apply only to residential agents. The benefit of this is that it is much easier to know how the law will be applied because there is already existing case law on the topic. Below is a summary of the Huijers v. DeMarrais case which illustrates why these agency disclosures must be provided strictly in accordance with the Civil Code and why "close enough" or "substantial compliance" may not be enough to save the broker's commission and the principal's transaction.  

What does SB 1171 do and why does it matter?

Because commercial brokers are required to make these disclosures, and because the Civil Code is so specific about the requirements, if not followed exactly, an unhappy buyer, seller, landlord or tenant will have a much easier time of rescinding a contract.

What does SB 1171 do? First, if you're not already familiar, feel free to jump below and read more about the specific disclosures required by the Civil Code. Since the early 1980s, the California Civil Code has required residential agents to make two agency disclosures, including an initial preprinted form disclosure explaining the types of agency relationships (seller's agent, buyer's agent, dual agent), and later a second disclosure specifying what type of relationship the agent and principal are going to have in a particular transaction. This framework was meant to ensure the principal gave its "informed consent" to the agency relationship. (The first disclosure "informs" or educates the principal, and the second disclosure gets the principal's consent.)  Additionally, although drafted to refer to a "buyer" and "seller", the disclosure requirements have always applied equally to transactions with landlords and tenants in leases exceeding one year.  

So again, with that background, what does SB 1171 do? All it does is require commercial brokers to make these same two disclosures to their principals in commercial transactions. Other than requiring commercial brokers to make these disclosures – at the specified times and in the specified forms – SB 1171 does not impose any additional duties on commercial brokers, even when acting as dual agents.  Dual agents, meaning agents representing both principals in a transaction, have always had the same duties to their principals and have always faced increased scrutiny by the courts, regardless of whether acting in a commercial or residential transaction.

What has changed, however, is that now because commercial brokers are required to make these disclosures, and because the Civil Code is so specific about the requirements, if not followed exactly, an unhappy buyer, seller, landlord or tenant will have a much easier time of rescinding a contract or fighting over a commission by claiming that it was not properly informed of the nature of the agency relationship and therefore did not properly consent. This is what happened in the Huijers v. DeMarrais case below.

Huijers v. DeMarrais – Fail to provide a disclosure on time, and get a rescission notice the day after the contract is signed.  

  "CLOSE" IS NOT GOOD ENOUGH

"CLOSE" IS NOT GOOD ENOUGH

A good example of how things can go badly by simply missing the timing requirements in the Civil Code is the Huijers v. DeMarrais case, 11 Cal.App.4th 676 (1992). Although this case involves a residential property (actually, a quasi-residential property it was a nursery with a residence on it), the court interpreted the same disclosure requirements that now apply to commercial brokers, and the parties involved were fairly sophisticated.

You'll be interested to read through the facts below, but here is the summary: A broker represented both a buyer and a seller and was found to have acted "in a fair and neutral manner." However, because the broker did not provide the seller with the agency disclosure form required by the Civil Code before the listing agreement was signed, even though the form was ultimately provided before the purchase agreement was signed, the California Court of Appeal held that the broker had no right to a commission and that the seller may have grounds to rescind the purchase agreement. That's noteworthy because all parties appear to have been sophisticated, negotiated at length (7-8 hours), and the broker's only failure was that she failed to provide a one page form disclosure to the seller at the right time. 

Huijers v. DeMarrais 

. . . If you're a broker, you have the same duties to your principals that you have always had; however, regardless of whether you actually satisfy those duties (as the broker in the Huijers case did!) you must make the disclosures required by the Civil Code when and in the form required by the Civil Code. And if you're a principal, you need to ensure your broker has complied.

In Huijers, a buyer engaged a broker to find a nursery property for an exchange.  The broker contacted an owner/seller that had a nursery property with a residence on a portion of the parcel.  The broker told the seller that she had a client interested in buying the property and the seller signed an exclusive listing agreement. There was one problem though – because the property had a residence on it, it was a residential property and the form disclosure statement required under the Civil Code had to be provided before the listing agreement was signed. (Note that the case references Section 2373 which was the numbering in effect at the time of the case but the requirements have not changed.)

The listing price was $325,000 and the buyer agreed to pay that price. The buyer, seller, and broker met in person and negotiated for about seven to eight hours.  At the end of the negotiation, the parties signed the purchase agreement, and the broker provided the seller with the form disclosure statement required under the Civil Code (so it was provided, but provided late because it was supposed to be given to the seller before entering into the listing agreement). The purchase agreement also documented that the broker was acting as a dual agent.

The next morning ­­– after the buyer and seller negotiated for 7-8 hours and signed the purchase agreement – the seller’s attorney called the broker and buyer and informed them that the seller was rescinding (i.e., cancelling the agreement just signed). The buyer sued for specific performance and damages, and the seller responded by counter suing the buyer and broker for among other things fraud and breach of fiduciary duty. (This is the typical course of things when transactions unravel, and if you sue, expect to be counter sued, and if you are a broker, expect to be sued by at least one, sometimes both principals.)

The trial court held that the purchase agreement was enforceable and that the broker and buyer had not made any misrepresentations or breached any fiduciary duties. In fact, the trial court expressly found that the broker committed no fraud and that she represented "... the interests of both plaintiff and defendants in a fair and neutral manner."  However, the seller appealed, and the court of appeal held that the seller had the right to rescind the listing agreement and (likely, pending further proceedings) the purchase agreement because the broker failed to provide the form disclosure statement when required under the Civil Code.

In its decision, the court walked through the Civil Code provisions – the same requirements outlined below that now also apply to commercial brokers – and found, correctly, that the timing requirements had not been satisfied by the broker. 

The buyer tried to defend against the rescission of the purchase agreement by arguing that the broker was in substantial compliance because, although the disclosure form was not provided before the listing agreement was entered into, the form was nevertheless provided when the purchase agreement was signed. However, the court found that providing the disclosure form after the time required by the Civil Code did not satisfy the objective of the statute.

The court explained the disclosure requirement, specifically with regard to timing, as follows:

The objective of a statute requiring a disclosure prior to signing the listing agreement is to allow the seller to make a more intelligent decision about whether to sign. For example, the property owner who is asked to sign a listing agreement because the broker has a buyer for the property may not fully comprehend that the broker intends to act as a dual agent. Because the seller pays the broker's commission, the seller may reasonably believe the broker has only the seller's best interest at heart and is working exclusively for the seller.

The disclosure form tells the property owner that a broker can act as a dual agent. Thus advised, the seller may wish to sell the property through his or her own agent or to seek independent advice on the price and terms of the listing.

The full measure of protection that the Legislature intended to provide to the seller cannot be achieved if the listing agent fails to provide the disclosure form prior to entering into the listing agreement. Because a reasonable objective of the statute is to give the seller information prior to signing the listing agreement, providing a disclosure form after the seller signs the agreement is not substantial compliance.

The court then imposed the rather harsh rule applicable to the broker's failure, which is essentially that the unhappy principal doesn't have to pay a commission and can avoid (i.e., rescind) the transaction, regardless of whether the principal was damaged by the failure:

The remedy for a real estate agent's breach of a duty to disclose a dual representation of both buyer and seller is that the principal is not liable to pay the agent's commission, and the principal may avoid the transaction. (McConnell v. Cowan (1955) 44 Cal.2d 805, 809) "... It makes no difference that the principal was not in fact injured, or that the agent intended no wrong or that the other party acted in good faith ...." (Id., at pp. 809-810.)

You might be thinking, "Yeah, but the broker told the seller from the beginning that the broker's 'client' was going to be the buyer, and the seller knew from then on that the broker was acting as a dual agent. However, the court clearly stated that the mere disclosure of dual agency was not enough:

[i]t is not enough to disclose only the fact of dual representation. The agent must also disclose all facts which would reasonably affect the judgment of each party in permitting the dual representation. . . . We read section 2375 [Now Section 2079.14 et seq.] as a legislative determination that the information required to be disclosed alerts the parties to the potentially harmful consequences of dual representation, so they can make an informed judgment."

And there you have it – Not only must brokers make the disclosures on time, but they must make the disclosures in the form required under the Civil Code because California courts have found this to be a legislative determination of the information required to be disclosed for a principal to give its informed consent.

The take away is this: If you're a broker, you have the same duties to your principals that you have always had; however, regardless of whether you actually satisfy those duties (as the broker in the Huijers case did!) you must make the disclosures required by the Civil Code when and in the form required by the Civil Code. And if you're a principal, you need to ensure your broker has complied.

Agency Disclosures Required Under the Civil Code – What, When, and How.  

Now that you know why complying with the Civil Code disclosure requirements is so important, below is an overview of what disclosures must be made, and when and how they must be made.  

Two disclosures are required: 

1. Preprinted Disclosure Form Regarding Real Estate Agency Relationship and Duties.

First, a form "Disclosure Regarding Real Estate Agency Relationship" (in the form provided in the Civil Code) must be delivered to the principals in the transaction. (A listing agent must deliver the form to the seller, and a selling agent must deliver the form to both the seller and the buyer.)

The agent providing the disclosure form must receive an acknowledgement of receipt *signed* by the principal receiving the disclosure (subject to limited exceptions noted below).

2. Disclosure Regarding Nature of Agency In Transaction.

Second, as soon as practicable, the principals in the transaction must be informed of the nature of the agency relationship, i.e., whether the agent is acting exclusively for the seller, buyer, or as a dual agent. (A listing agent representing only the seller must make this disclosure only to the seller. A selling agent must make this disclosure to both the seller and buyer *even if only representing the buyer*.)

In each case, the agency relationship must be confirmed in a writing executed or acknowledged by the disclosing agent and the principal or principals receiving the disclosure. (The writing may be the purchase agreement or lease, but better practice is likely to always include a separate disclosure form that is signed as soon as the nature of relationship is known.)

Changes Implemented By Senate Bill 1171.

The disclosure requirements implemented by Senate Bill 1171 are found in Civil Code Sections 2079.13 to 2079.24. Here is a link to the full text of Sections 2079-2079.24 (you'll need to scroll down to Section 2979.13).  

As noted above, since the 1980s, the Civil Code has required residential brokers and salespersons to make disclosures regarding the nature of agency relationships and in what capacity the broker or salesperson is acting in the specific transaction, and all that SB 1171 has done is to extend these requirements to commercial brokers. 

In total there are only three changes to the Civil Code:

First, the title of the article has been revised to refer to "Real Property" not just “Residential Property”:

Article 2. Duty to Prospective Purchaser of Residential Real Property

Second, Section 2079.13, which defines various terms, was revised to include a new definition for "Commercial Real Property":

(d) “Commercial real property” means all real property in the state, except single-family residential real property, dwelling units made subject to Chapter 2 (commencing with Section 1940) of Title 5, mobilehomes, as defined in Section 798.3, or recreational vehicles, as defined in Section 799.29.

Third, the previous definition for "Real Property" included under Section 2079.13 was revised to include the newly defined term, commercial real property:

(j k) “Real property” means any estate specified by subdivision (1) or (2) of Section 761 [i.e., meaning fee title or a life estate] in property which that constitutes or is improved with one to four dwelling units, any commercial real property, any leasehold in this type these types of property exceeding one year’s duration, and mobilehomes, when offered for sale or sold through an agent pursuant to the authority contained in Section 10131.6 of the Business and Professions Code [i.e., sale of registered manufactured home or mobilehome].

As you review the disclosure requirements, remember the following: 

  • All Real Property – The result of the changes above is that the disclosure requirements now apply to all real property in the state, other than certain unregistered mobilehomes. 
    .
  • All Leases Exceeding a Year – Although the disclosures speak strictly in terms of purchase and sale transactions and refer to sellers and buyers, Civil Code Section 2079.13(m) expands the definition of "sell", "sale" or "sold" to include "transactions for the creation of a leasehold exceeding one year’s duration." So remember that these requirements now apply to essentially all commercial leases. 
    .
  • Signed  Subject to few exceptions as noted below, the Civil Code requires the disclosure form to be signed. 

Required Disclosure 1 – Preprinted Disclosure Form.

First, Section 2079.14 requires agents to deliver the form "Disclosure Regarding Real Estate Agency Relationship" provided in the Civil Code to the principals in a transaction and to obtain a signed acknowledgement of receipt from the principal receiving the disclosure.  

1. The listing agent must provide the disclosure form:

  • To seller – before entering into the listing agreement [Section 2079.14(a)].  The listing agent need not provide the disclosure form to the buyer unless the listing agent is also acting as the selling agent. 

2. The selling agent must provide the disclosure form:

  • To seller – as soon as practicable prior to presenting the seller with an offer to purchase. (If the selling agent is also the listing agent and has already provided the disclosure form, there is no need to provide it again.)  [Section 2079.14(b)]
    • Here there is one exception where a selling agent does not need to obtain a signed disclosure form from the seller: If the selling agent is not in direct contact with the seller, the selling agent still needs to prepare and provide a disclosure form to the seller; however, (a) the selling agent can either prepare the form and give it to the listing agent to have the seller sign it and return it, OR (b) the selling agent can mail the disclosure form to the seller's last known address by certified mail. In the latter case, no further acknowledgement from the seller is required.  [Section 2079.14(c)]
      .
  • To buyer
    • If the selling agent prepares the offer to purchase, as soon as practicable prior to execution of the buyer's offer to purchase. [Section 2079.14(d)]
      .
    • If the selling agent does not prepare the offer to purchase, no later than the next business day after the selling agent receives the offer to purchase from the buyer.  

In each case, an agent is required to "obtain a signed acknowledgement of receipt" from the principal receiving the disclosure form. [Section 2079.14]  However, if the principal for some reason refuses to sign an acknowledgement, an agent must document the refusal by preparing, dating, and signing a written declaration stating the facts of the refusal. [Section 2079.15]   

Form of Preprinted Disclosure: 

The California Association of Realtors has long had a disclosure form complying with the requirements of Civil Code Section 2079.14; however, if you are preparing your own form, the exact text required is in Civil Code Sections 2079.13-.24. Section 2079.16 specifies that the disclosure form must have the text of Section 2079.16 on the front of the disclosure form, and printed on the back, have Sections 2079.13 to 2079.24, inclusive (excluding only Section 2079.16 which of course is printed on the front). The front and back of the form would appear (without much formatting) as follows:

Required Disclosure 2 – Nature of Agency In Transaction.   

Second, Section 2079.17 requires agents to disclose to the principals in a transaction what capacity they are acting in.  

Selling Agent. A selling agent is required to disclose to both the buyer and the seller, as soon as practicable, whether the agent is acting exclusively as the buyer's agent, exclusively as the seller's agent, or as a dual agent representing both parties.

Listing Agent. If a listing agent is also representing a buyer, the agent is by definition a dual agent and must make the disclosure noted above. However, even if a listing agent is only representing the seller, while the agent is not required to make a disclosure to the buyer, the agent must nevertheless disclose, as soon as practicable, to the seller that the agent is acting exclusively as the seller's agent. 

Documented in Writing Before or at the Time the Purchase Agreement/Lease is Entered Into. In each case, the agency relationship must be further confirmed in a writing signed or acknowledged by the disclosing agent and the principal or principals receiving the disclosure before or at the same time as the purchase agreement or lease is entered into. This "writing" documenting the agency relationship may be the purchase agreement or lease itself; however, it may be a better practice to always include a separate document apart from the purchase agreement or lease that is signed by the principals and brokers.

The confirmation of the agency relationship is required to be in the following form: 

_______________________________________________
(Name of Listing Agent)

is the agent of (check one):

( ) the seller exclusively; or
( ) both the buyer and seller.

_______________________________________________
(Name of Selling Agent if not the same as the Listing Agent)

is the agent of (check one):

( ) the buyer exclusively; or
( ) the seller exclusively; or
( ) both the buyer and seller.

Why after California's Riverisland case it’s easier than ever for a party to claim you promised something different from what’s in your contract and how “big boy” provisions can help.

crossed-fingers-363478_640.jpg

If you enter into a contract (including a lease, purchase agreement or any other written agreement), what happens if the other party later claims you promised something that's different from what’s in the contract?    

In California, for over 78 years there’s been a rule that generally protected parties from these sorts of claims. The rule prevented one party to a contract from suing the other for fraud based on alleged promises or representations that were contradicted by the express terms of the contract. In other words, if the contract said I would do X, you couldn't sue me for fraud claiming that I really promised Y.

But this rule, called the Pendergrass rule based on a 1935 case with the same name, was thrown out in 2013 by a California Supreme Court in the Riverisland case discussed below. And while the Riverisland case was worrisome enough, a case that followed it, the Julius Castle case, also discussed below, shows how easy it has become for one party to successfully sue the other for fraud based on allegations that are directly contradicted by their written contract. 

Why you should be worried:

The Riverisland and Julius Castle cases are discussed below in detail, but to keep you reading, here’s the short version of Julius Castle : A sophisticated landlord and tenant entered into a commercial lease for a restaurant property. In the lease the tenant accepted the premises "as is", and the landlord had no obligation to maintain or repair the restaurant equipment that had been left by the previous tenant. However, the tenant later sued the landlord for fraud and alleged that the landlord's agent promised *verbally* that the landlord would repair any faulty restaurant equipment. The result? After a jury trial, even though the written lease directly contradicted this alleged verbal promise, which the landlord continued to dispute was ever made, the tenant was awarded $205,800 in damages and $158,180 in attorney’s fees and costs.

How do you protect yourself from a similar result and avoid being sued for fraud based on an alleged promise you claim you never made that contradicts your written agreement?  The linchpin to a party’s claim for fraud is that it must show it justifiably relied on the alleged promise or representation, and one way to significantly undercut a party’s ability to show its reliance was justifiable, and therefore defeat the party’s claim, is to include a specific waiver of reliance or “big boy” provision in the contract.

Given the change in California law, which again did away with 78 years of precedent, if you are entering into an agreement that's vulnerable to these sorts of claims (which would include any complex transaction with significant prior negotiation), you should consider including a waiver of reliance provision.

Below is a discussion of the Riverisland and Julius Castle cases and of waiver of reliance provisions in California and other states. It’s a long post, so feel free to jump around.

Riverisland Cold Storage, Inc. v. Fresno-Madera Production Credit Assn. (2013) 55 Cal.4th 1169

Two ranchers sign and initial a loan modification agreement and then claim they never read it.

In Riverisland, two ranchers, after signing and initialing a loan modification agreement, claimed they never read the agreement and that the lender's agent verbally promised terms that were different from those that were in the written agreement. The ranchers had fallen behind on loan payments to their lender. The lender agreed to restructure the loan and prepared a modification agreement in which the lender agreed to forbear for three months if the ranchers made reduced payments and pledged eight parcels of real property as additional collateral.

The ranchers/borrowers signed the modification agreement and even initialed the pages with the legal descriptions for the additional parcels.  However, after entering into the agreement, the ranchers failed to make the reduced payments required. When the lender moved to foreclose, the ranchers sued the lender for fraud and claimed that even though they had signed the modification agreement and initialed all the pages, they never read the agreement and instead relied on the lender's representative's *alleged* promise that the loan would be would be extended for two years, not three months, and that they were only pledging two additional parcels of property, not eight.

How times have changed and why the Court overturned Pendergrass.

Based on the 78-year-old Pendergrass rule noted above, the ranchers' claim would have been denied because the alleged verbal statements of the lender's representative conflicted directly with the terms of the written agreement that the ranchers signed.  But times have changed.

While in 1935, the California Supreme Court was concerned that plaintiffs like the ranchers in Riverisland would perjure themselves by making up claims to get out of their agreements, today the Court fears the opposite and now worries that barring these claims, no matter how implausible, would encourage parties to promise things they had no intention of doing (or documenting).  And so in the Riverisland case, which you will likely seen referenced again and again in the coming years, the Court overruled Pendergrass and permitted the ranchers' claims to go forward, claims that essentially rewrote the modification agreement that the ranchers signed and initialed but claimed to have never read.

Why you shouldn’t dismiss Riverisland as being an insignificant change.

After the Riverisland case, legal commentators (and the Court itself) sought to soften the perceived impact of doing away with the old Pendergrass rule by reminding us that the new rule under Riverisland is followed by a majority of other states, and, more importantly, even if a plaintiff may now bring a claim for fraud that would have previously been barred, the plaintiff must still prove it justifiably relied on the alleged misrepresentation or false promise.

However, both of these points mean very little in practice. With regard to the first point, that other states follow a similar rule, the rule is still new in California and leaves 78 years of precedent in question with little clear direction from the courts on what the limits of a plaintiff's potential claims will be. Simply put, in 2012 a party could not claim that it relied on a statement that conflicted with a written contract. Today, the party can. This change exposes contracting parties to a new risk, especially with regard to the type of alleged verbal statements at issue in the Riverisland and Julius Castle cases, and while parties in other states, can look to their state's precedent to gauge and manage that risk, parties in California cannot.  

With regard to the second point, that a plaintiff must nevertheless show it justifiably relied on an alleged promise, a few more facts from the Julius Castle case below will show how low that standard actually is, especially when a jury is deciding the issue.

Julius Castle Restaurant Inc. v. Payne, 216 Cal.App.4th 1423 (2013)

2131111817_cf09075243_o.jpg

The Julius Castle case shows how easy it can be for a party to prevail when claiming the other party made a promise or representation that wasn't documented. The case involved two experienced restaurant operators who entered into a long-term lease for a historic restaurant property. After operating for just six months, the tenants closed their business. Instead of walking away, they sued their landlord for damages for the lost business opportunity of selling the restaurant.  The tenants claimed that their six-month old business was profitable every month (even though they failed to pay sales taxes, began withholding payments to the landlord, and stopped paying their vendors and lender).

The tenants' primary claim was that the landlord, through his agent, promised during lease negotiations to repair any faulty restaurant equipment. The landlord had inherited the equipment from the previous restaurant tenant. The landlord denied ever promising to repair the equipment or fix anything else on the premises, and the lease did not include such an obligation. Instead, the lease provided that the tenants were taking the property "as-is".

What's more, before the tenants signed the lease, they were fully aware that the lease did not require the landlord to repair the equipment. As the court noted, the parties "went through every page of the Lease together to ensure they were all satisfied with the document." Over several weeks of negotiating and drafting the lease, the tenants "asked many questions so that they would feel confident and satisfied with the final version" and testified that they "did not feel rushed." 

Despite weeks of reviewing, negotiating and apparently revising the lease on other issues, when it came to the landlord's alleged promise to repair the restaurant equipment, the tenants testified that they did not require the lease to be modified to reflect that point because "the obligation was already implied and [the landlord] had already promised to make any needed repairs."

Justifiable reliance?

Remember that in Riverisland, one of the justifications for allowing these sorts of claims to go through was that even if a party could now base its fraud claim on an alleged statement that was contradicted by the parties' written agreement, the party would still have to show that it justifiably relied on the statement. But as Julius Castle shows, in practice "justifiable reliance" does not mean much.

In Julius Castle, the tenants were sophisticated, negotiated and reviewed the lease at length, and knew what was and was not in the lease.  The tenants requested multiple other revisions to the lease, but when it came to the condition of the restaurant equipment, which the tenants testified was critical to their business, they allegedly decided there was no need to incorporate the landlord's promise because it was already implied . . . and the jury agreed that this was justified.

But when would a party ever be justified in relying on a verbal statement about a material, even critical issue, when the written agreement says the opposite, and the party knows the written agreement says the opposite and has the power to revise the agreement?

The answer is never, and the fact that the jury didn't get that is why you shouldn't find much comfort in the idea that if a party sues you for fraud, the party won't be able to show justifiable reliance. If the tenants in Julius Castle were able to show justifiable reliance, it's hard to imagine what sort of plaintiff could not.  

Waivers of Reliance -- Undercutting a party's justifiable reliance on extra-contractual promises and representations.

What should you do to protect yourself from the type of claims the lender and landlord were faced with in the cases above?

chop_down_tree_7412.png

First, remember that the issue not whether a plaintiff can claim you promised or represented something that didn’t make its way into the contract. (There are almost always promises or representations that don't make it into the final agreement -- that's called negotiation.) The issue is whether a plaintiff can justifiably rely on promises or representations that were not ultimately documented as part of the parties’ final deal. Accordingly, anything you can do to chip away at the justifiableness of a party’s reliance will help.

 As a preliminary matter, take the time to ensure your contract is clear on material points. In Julius Castle, if the restaurant equipment was discussed and an important issue, beyond the "as is" clause, the landlord would have been helped immensely if the lease affirmatively required the tenant to maintain and repair the equipment.  Additionally, whenever there’s an opportunity to put something in writing, even if simply an informal email confirming a point or denying a request, do it.  

Beyond that, the best way to build a certain amount of protection into your contracts, even if not 100%, is to include a waiver of reliance or “big boy” provision that expressly states that each party is not relying on any promises or representations not incorporated in the final contract. As discussed below, although most contracts do include an “integration clause” stating that the parties' contract is the final agreement and that there are no other promises or representations, there is difference between saying “there are no other representations” and saying “I am not relying on any other representations.”

Waivers of Reliance in Other States

In other states which never had the benefit of the Pendergrass rule and seem to have more precedent on these types of issues, commercial contracts often (and apparently increasingly) include waiver of reliance or "big boy" provisions. A New York case, Danann Realty Corp. v. Harris, 5 N.Y.2d 317 (1959), illustrates nicely how this sort of provision can destroy a plaintiff’s ability to claim it relied on promises or representations made outside of the contract. 

In the case, a purchaser of commercial property claimed the seller misrepresented the property’s profitability; however, in the purchase agreement, the purchaser agreed as follows:

 "The Seller has not made and does not make any representations as to the physical condition, rents, leases, expenses, operation or any other matter or thing affecting or related to the aforesaid premises, except as herein specifically set forth, and the Purchaser hereby expressly acknowledges that no such representations have been made, and the Purchaser further acknowledges that it has inspected the premises and agrees to take the premises `as is' * * * It is understood and agreed that all understandings and agreements heretofore had between the parties hereto are merged in this contract, which alone fully and completely expresses their agreement, and that the same is entered into after full investigation, neither party relying upon any statement or representation, not embodied in this contract, made by the other."

The court focused in on the language above, particularly the last line stating that neither party was relying on any statement or representation not embodied in the contract. The court determined that the plaintiff had no cause of action for fraud because “[s]uch a specific disclaimer destroys the allegations in plaintiff’s complaint that the agreement was executed in reliance upon these contrary oral representations.”

And in a rather nice twist of logic, the court reasoned that the plaintiff itself, by bringing a claim for fraud that contradicted its disclaimer, was committing a sort of fraud:

"[P]laintiff made a representation in the contract that it was not relying on specific representations not embodied in the contract, while, it now asserts, it was in fact relying on such oral representations. Plaintiff admits then that it is guilty of deliberately misrepresenting to the seller its true intention. To condone this fraud would place the purchaser in a favored position."

For an excellent review of these sorts of provisions and their enforceability in other states, see this article

Waivers of Reliance in California

In California, provisions waiving reliance on statements made outside of the contract do not provide 100% protection, but they can be very helpful.

First, note again that it’s not enough to simply state that there are no other promises or representations except as provided in the agreement. The lease in Julius Castle  had an integration clause that stated just that and read: “Any agreement or representations respecting the Premises or their leasing by Landlord to Tenant not expressly set forth in this instrument are void.” But this sort of statement is not a waiver of reliance and does not prevent a party from claiming that there were other statements made outside of the contract that it relied on. See Ron Greenspan Volkswagen, Inc. v. Ford Motor Land Dev. Corp., 32 Cal. App. 4th 985 (1995) (finding a similar clause stating "[n]o express or implied representations, warranties, or inducements have been made by any party to any other party except as set forth in this Agreement" could not prevent a claim for fraud).* 

To get any sort of protection, the parties must actually agree that they are not relying on any extract-contractual promises or representations. Several courts applying California law have found that this sort of clause -- a true waiver of reliance -- limits a plaintiff's ability to show that its reliance on statements not documented in the contract was justifiable.

In a 2005 leasing case, Hinesley v. Oakshade Town Center, involving a retail lease in a shopping center, a tenant sued its landlord for fraud and rescission of the lease claiming that the landlord's agent told the tenant during negotiations that a regional restaurant chain Dos Coyotes, a Starbucks, and a Baskin-Robbins ice cream shop would all be opening near the premises the tenant was leasing. (Side note: Do you see the pattern? The alleged fraudulent statement is always made by the landlord's agent and is always verbal.)  The lease, however, expressly disclaimed the tenant's reliance on such statements:

"Lessee does not rely on the fact nor does Lessor represent that any specific Lessee of [sic] type or number of Lessees shall during the term of this Lease occupy any space in the Shopping Center."

Relying in large part on the language above, the court held that the tenant could not have, as a matter of law, justifiably relied on the alleged statements by the landlord's agent. Again, distinguishing between a common integration clause and a waiver of reliance, the court noted that this language "was not merely a generic integration/no oral representations clause. The language specifically stated, "Lessee does not rely on the fact nor does Lessor represent . . ." and "such express language should have conveyed the implication [to the tenant] that the lease did not come with a guarantee that any particular businesses would be or stay cotenants . . .. The clause should have put [the tenant] on notice to ask further questions. The clause is certainly a factor to consider in determining whether [the tenant] justifiably relied . . .." Hinesley v. Oakshade Town Center , 135 Cal. App. 4th 289 (2005).

Other cases have reached similar results: Paracor Finance, Inc. v. General Electric Capital Corp., 96 F.3d 1151, 1159 (9th Cir. 1996)  (court concluded that plaintiffs' “contractual representation that they did not rely on any other person goes far to defeat their present claims that they did precisely the opposite and relied on [defendant].”); Bank of the West v. Valley National Bank of Arizona, 41 F.3d 471, 478 (9th Cir. 1994) (court held that "the contract could and did control whether . . . reliance would be 'justifiable' for purposes of a fraud claim" and given the plaintiff's promise in the contract to act "independently and without reliance" on the defendant, it had no right to then do the opposite); Lancer Offshore, Inc. v. Dominion Income Mgmt. Corp., 01 CIV. 4860 (LMM), 2002 WL 441309 (S.D.N.Y. Mar. 20, 2002) (court held in the context of a settlement agreement that a plaintiff could not sustain a claim for fraudulent inducement where the parties agreed they did not rely on any representations made by the other party and assumed the risk of any unknown or  concealed facts or information).

Final thoughts on crafting your own waiver of reliance provision.

 It’s clear that at least in California, post Riverisland, there is an increased risk of litigation from a party claiming that it relied on alleged promises or representations that were never documented.  Including a waiver of reliance provision may prevent a party from claiming it justifiably relied on any undocumented promises or representations, and even if such a provision is not ironclad, it's still worth adding. If you doubt that, remember the Julius Castle landlord who paid hundreds of thousands of dollars to a tenant that occupied for his property for just a few months because of an alleged verbal statement by the landlord's agent.

So if you are going to include a waiver of reliance provision, what should it say? As the discussion above makes clear, it's not enough to say there are no other promises or representations. At minimum the parties need to clearly agree they are not relying on any other promises or representations not included in the contract. Beyond this fundamental statement, what else should be covered?

A good place to start is to think about what's implied when you sign a contract (meaning as a sophisticated party entering into a commercial contract, not as a consumer signing whatever's put in front of you). At a minimum, you are agreeing to be bound by the terms of the contract. And it follows from that, that you are also indicating that you've read and understood the terms you'll be bound by, and to the extent you haven't, that you are nevertheless assuming the risk of complying with such terms. In addition, there's an implication that if a term is material to you and is not in the contract or is not correct or clear, you will speak up and ask for the contract to be revised .

A waiver of reliance provision might make these implications express agreements by the parties by covering the following points and clarifying that each is a material part of the consideration: 

  1. each party has read the entire agreement;
  2. understands all of the provisions in the agreement and has requested modifications to the extent necessary to ensure this agreement clearly and completely reflects the party’s understanding;
  3. is not relying on any statement, representation, warranty, agreement or promise made by the other party, or any of the other party’s employees, agents, or contractors, that is not set forth in the agreement; and
  4. assumes the risk of any such statement, representation, warranty, agreement or promise not being set forth in this agreement. 

Given the tendency of plaintiffs to claim they didn't read the agreement (or at least the part about waiving reliance), it's also a good idea to require the parties to initial a provision like this. 

In addition to these basics, consider the proper scope of a waiver of reliance. Such a provision could be a double-edged sword, and courts are generally less willing to enforce provisions that seem overly broad or generic. So narrowing the scope could help on both fronts. The Hinesley cases has a good example of a very narrow waiver -- it applied only to cotenants. As another example, if you are only concerned with the type of claims brought by the plaintiffs in the Riverisland and Julius Castle cases, you might limit the waiver to verbal statements that conflict with the terms of the written agreement.

Finally, for specific types of transactions, another way of making a waiver of reliance provision more specific (and thus more likely to be enforced) and at the same time adding a sort of checklist for the parties would be to list out specific issues that the wavier applies to, for example, specifying that a tenant is not relying on any representations or promises regarding other tenants, the size of the space, the condition of the property, operating expenses, maintenance and repair obligations, etc. As shown in Hinesley (and out of state cases referenced by the article cited above) this sort of specificity can make it even harder for a plaintiff to overcome the waiver. 


*As a side note,  another case often cited, McClain v. Octagon Plaza, LLC , 159 Cal.App.4th 784 (2008), regarding a landlord’s misrepresentation of the size of a premises, held that a disclaimer in the lease did not prevent the plaintiff from showing justifiable reliance; however, that case is different from the cases discussed above in that the representation regarding the size of the premises was in the lease itself. This article is concerned with limiting questionable claims like those in Riverisland and Julius Castle which are based on alleged statements outside of the agreement, particularly alleged verbal statements contradicted by the agreement itself.    

Photo credit: Photo of Julius Castle by ario_  (https://www.flickr.com/photos/ario/)

Jonathon Giebeler

Jonathon Giebeler is a graduate of the University of Southern California Law School, where he also earned a Master of Real Estate Development. His practice emphasizes commercial leasing representing landlords and tenants (including retail, office and industrial leases), real estate-secured finance, and the sale and purchase of real property.

Leasing Basics - Assignments, Subleasing, and Transfers, Part 3 – Grounds for Denial

This is Part 3 of the basic series I've been doing on assignments, subleasing and other transfers in commercial leases. As covered in Part 2, commercial leases commonly require a landlord’s consent to any assignment, sublease or other transfer of the lease, and often the parties will go one step further and include a negotiated list of grounds which the parties agree will give the landlord a reasonable basis for denying its consent to a transfer.

These grounds vary from lease to lease and may be property specific but typically relate to the transferee’s financial condition and background, the proposed use of the premises, and sometimes the terms of the transfer itself. 

Below is a list of several common grounds for denial, grouped roughly by whether they relate to the transferee, the transferee's use, or the terms of the transfer. For most, the landlord's perspective is self-explanatory, so often only the tenant's countering perspective is noted.

In addition to understanding the concepts behind these grounds for denial, you should also note how they are drafted in the lease. Often the concept itself is just fine, but it is drafted in a way that's too vague or subjective to provide a workable standard. In that case, instead of fighting about whether the provision should stay or go, see whether a revision might make the issue come across more clearly and objectively.    

Grounds For Denial Related to the Transferee:

1. The Transferee's creditworthiness, character or business reputation is unsatisfactory.

Tenant's Perspective: Generally acceptable. You'll see these phrased in all sorts of ways, and again, it's important that the standard be objective. What's "unsatisfactory"? A more objective standard would be that the transferee's credit and reputation are comparable to that of tenant and existing tenants in project, or even similar projects in the vicinity if the project happens to be quite small..

2. The transferee's financial condition or stability is insufficient to support its obligations under the lease or would increase the risk of default.

Tenant's Perspective: Also generally acceptable, and again, these come in all shapes and sizes. A common variation is a net worth test, requiring the transferee not to have a net worth less than the tenant. That may be fine; however, if the tenant has a net worth higher than necessary to service its obligations under the lease, this standard may be too restrictive. A strong tenant may also ask that this condition not apply to subleases (because the tenant and guarantors are still directly liable and often in possession) and, for any other transfer, take into account the continuing liability of the tenant or guarantors -- the argument being that often the landlord has less additional risk because the original parties are still on the hook.

3. The transferee is a current tenant in the project or a prospective tenant that landlord has negotiated with.

Tenant's Perspective: Generally unacceptable. Other tenants in the project or tenants a landlord has solicited are ideal transferees because they are already in, or interested in, the project. A strong tenant would delete this entirely. A tenant with less negotiating power would request exceptions (e.g., existing adjacent tenants). A tenant may also ask what the landlord's concern is and then address that concern.  For example, if a landlord is concerned about tenant mix and diversity, agreeing on not transferring to certain existing tenants.

4. The transferee is a governmental agency or instrumentality. 

Landlord's perspective: This is not always self-explanatory, so here is a bit of landlord's perspective: Like it or not, government uses often include denser, lower quality uses with a multitude of visitors that impact the common areas, conflict with other uses, and make the building generally less prestigious. Something I often see is a group of people lined up around a building waiting to get into the social security administration office. Most landlords (and their other tenants) don't want that. 

Tenant's Perspective: Often unacceptable. Most tenants would argue (and stronger tenants often successfully) that the landlord's concerns are legitimate but covered by other factors relating to the use (like those below) and that government agencies are often made up of professionals not working with the public. If the landlord is unwilling to delete the condition altogether, a tenant may fall back to condition the restriction on there being no government use then in the project.

Grounds For Denial Related to the Transferee's Use:

1. The transferee's use is different from the permitted use in the lease.

Tenant's Perspective: Generally acceptable; however, if the permitted use is narrow, which will more often be the case in a retail lease, then a tenant many ask for the right to request a change in use subject to reasonable conditions, which may be listed in the transfer provisions themselves (i.e., the other conditions appearing below), or in the use provision.   

2. The transferee's use would increase use of common area.

Tenant's Perspective: Generally acceptable with some revisions. The concept behind this ground is fine; however, to ensure it is not used to bar any sublease (which often results in additional uses and thus additional use of the common area), a tenant might ask to require that any increase in use be materialand incompatible or disproportionate to the use by other tenants in the project.      

3. The transferee's use is adverse to or would interfere, conflict, or compete with use of landlord or existing tenants.

Tenant's Perspective: Generally acceptable in a retail setting; however, if this shows up in a general office lease, a tenant may request that it be deleted or inquire into what the landlord's concern is. For example, a condition on not interfering with other tenants is hard to object to, but what does competition mean in an office setting?  

4. The transferee's use would violate an agreement the landlord is a party to or that affects the project.

Tenant's Perspective: Generally acceptable. This often arises in retail leases where a landlord has granted exclusives to other tenants or the project is subject to CC&Rs.

5. The transferee's use would be less prestigious or otherwise inconsistent with character and quality of project. 

Tenant's Perspective: Generally unacceptable. The concept here is fine, but as expressed, it's too vague and subjective. If many of the other grounds above have been included, a tenant might reasonably argue that the landlord's concerns are covered. But if a landlord still wants a catchall provision, a better one would be that the use will not be inconsistent or incompatible with the project and the existing uses in the project. (But again -- this point may already be covered by other grounds).

6. The transferee will pay less percentage rent (i.e., its gross sales will be lower).

Tenant's Perspective: Generally acceptable in a retail setting, for obvious reasons. If the landlord negotiated base rent and percentage rent based on the tenant’s business and projected gross sales, that is the economic deal. That said, a careful tenant may ask to exclude any reduction in percentage not caused by the transfer (e.g., due to general economic conditions vs. a change in use or trade name). And if a tenant felt that it needed more wiggle room, it might request that the condition instead be based on the projected aggregate of base rent and percentage rent, since a reduction in percentage rent can be offset by increasing the base rent. 

Grounds For Denial Related to the Transfer Itself:

1. The transfer is of less of less than the entire premises or term. 

Tenant's Perspective: Generally unacceptable. This would prohibit most subleases, and unless the landlord is agreeing to recognize a sublease if the tenant defaults, the other conditions adequately cover any concerns a landlord may have.  

2. The transfer will result in alterations.   

Tenant's Perspective: Often unacceptable. Many subleases require alterations. A tenant may want to soften this, for example by providing that the transfer will not result in any alterations reasonably objectionable to the landlord (so that the fact that there will be alterations is not itself automatically a ground for denial) or even exclude alterations resulting from demising walls or other customary alterations made in connection with a sublease.

3. The transferee will pay less rent than the rent quoted by the landlord in the project.

Tenant's Perspective: Generally unacceptable. Subleases will always been discounted because, recall from Part 1, there is no direct relationship with landlord, and unless a landlord agrees to recognize a sublease, a subtenant gets wiped out if the tenant's lease is terminated. Additionally, there is little need to push a tenant to get the best deal it can on a transfer because most leases provide that the tenant will keep all or a portion of any rent in excess of that due under the lease, and even if there is no excess rent, the tenant will of course be trying to minimize its downside, that is, the difference between the rent it pays under the lease and the rent it gets under a sublease.    

Landlord's Perspective: That said, a landlord may have a legitimate basis this condition, particularly if the tenant was given a below market deal with material concessions.  In that case, a landlord does not want a tenant competing with it as it tries to lease up the building. If this is the case, a tenant may need to scale back from deleting the provision agree that it will apply until the building is leases or during an initial term or negotiate for a lower percentage of the rent quoted by the landlord.

4. The tenant is in default at the time it requests a transfer.

Tenant's Perspective: Generally unacceptable. This is a sort of gotcha that stronger tenants object to (and that landlord's do not need to feel guilty about deleting). If the tenant is in default, the landlord has its remedies under the lease, e.g., send a notice and demand cure, and if there is no cure, evict; however, if the landlord has decided to forbear (a typical example is when a tenant finds itself in trouble and is paying rent, but not all rent), that decision should not cut off the tenant's lifeline, which is a sublease, assignment or other transfer. The landlord should be covered by all of the other grounds discussed above.


AIR Form Comparison: The only ground for denial expressly listed in the AIR forms is that the landlord may deny any proposed assignment or subletting if the tenant is in default at the time consent is requested. This of course is the ground discussed immediately above. As for the lack of other grounds for denial in the AIR forms, as covered in part 2, including a list of grounds for denial in a lease is not required, but for larger leases has become fairly standard and may benefit both parties by providing a framework for proposed transfers.